Monolithic Power Systems' (NASDAQ:MPWR) Conservative Accounting Might Explain Soft Earnings

The most recent earnings report from Monolithic Power Systems, Inc. (NASDAQ:MPWR) was disappointing for shareholders. Despite the soft profit numbers, our analysis has optimistic about the overall quality of the income statement.

View our latest analysis for Monolithic Power Systems

Zooming In On Monolithic Power Systems' Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. To get the accrual ratio we first subtract FCF from profit for a period, and then divide that number by the average operating assets for the period. This ratio tells us how much of a company's profit is not backed by free cashflow.

Therefore, it's actually considered a good thing when a company has a negative accrual ratio, but a bad thing if its accrual ratio is positive. That is not intended to imply we should worry about a positive accrual ratio, but it's worth noting where the accrual ratio is rather high. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Over the twelve months to September 2024, Monolithic Power Systems recorded an accrual ratio of -0.27. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. In fact, it had free cash flow of US$679m in the last year, which was a lot more than its statutory profit of US$434.2m. Monolithic Power Systems shareholders are no doubt pleased that free cash flow improved over the last twelve months.

That might leave you wondering what analysts are forecasting in terms of future profitability. Luckily, you can click here to see an interactive graph depicting future profitability, based on their estimates.

Our Take On Monolithic Power Systems' Profit Performance

Happily for shareholders, Monolithic Power Systems produced plenty of free cash flow to back up its statutory profit numbers. Based on this observation, we consider it possible that Monolithic Power Systems' statutory profit actually understates its earnings potential! And on top of that, its earnings per share have grown at an extremely impressive rate over the last three years. At the end of the day, it's essential to consider more than just the factors above, if you want to understand the company properly. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. At Simply Wall St, we found 1 warning sign for Monolithic Power Systems and we think they deserve your attention.

This note has only looked at a single factor that sheds light on the nature of Monolithic Power Systems' profit. But there is always more to discover if you are capable of focussing your mind on minutiae. Some people consider a high return on equity to be a good sign of a quality business. While it might take a little research on your behalf, you may find this free collection of companies boasting high return on equity, or this list of stocks with significant insider holdings to be useful.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.